Interest Rate Risk and the Examiners

Like everyone else, Eagle Community Credit Union has weathered what CFO Scott Rains described as several years of blustery economic conditions. What’s more, the $206 million institution, located in the Orange County, Calif., community of Lake Forest, has prospered almost in spite of guidance given by its examiners.

Eagle Community, which serves 18,000 members including many federal employees, has few mortgages on its books and is primarily focused on short-term member loans. To help the credit union stay financially viable as the loan market softened in recent years, Rains rolled 50% of the credit union’s assets into investments. But volatile interest rates and a changing economic climate have started to threaten earnings even from that portfolio.

“We’ve had some pretty substantial unrealized losses [on investments] in the past nine months,” said Rains. “It’s about $2 million on an $80 million portfolio, but we’re very comfortable with that and I don’t have anything better to put my money into right now.”

The losses occurred on the investment’s mark-to-market values, which measure lost revenue potential through rate changes rather than a declining principal value. Unfortunately, the NCUA examiners under whose scrutiny Eagle Community falls were less comfortable than the credit union with the losses.

“The NCUA comes at this from a very different perspective,” Rains said. “They’re all about safety and soundness, but we have to make money.”

Cultivating earnings potential while staying within NCUA’s prescribed regulatory guidelines can be a risky business, admit examiners and credit union executives alike. Managing interest rate risk is a challenge faced by all credit unions, and one that’s likely to be compounded when rates eventually begin to rise. When that day finally comes, credit unions whose cash flow streams fail to balance with their funding streams may find themselves very uncomfortable indeed.

“We get concerned in a situation when a change in interest rates stresses income or creates very large changes in asset valuation,” said John Worth, NCUA’s chief economist. A changing rate environment can weaken the value of fixed-rate assets at a time when depositors may demand higher rates just to keep money in their member accounts. The result, Worth explained, can be a compressed net margin that can wind up threatening a credit union’s financial strength and stability.

“That’s really the crux of it,” Worth said. “A stress to earnings, a stress on asset values and a reduction in liquidity can create a significantly stressful environment for the credit union. That’s where we have concerns about interest rate risk.”

That’s also the point at which credit unions like Eagle Community and others come to loggerheads with the NCUA. Walking the tightrope between safety and soundness and the need for profitability has rarely been more challenging than over the past few years.

Neither aspect can be sacrificed in pursuit of the other, and both parties have valid concerns, according to Brian Turner, chief strategist for Catalyst Strategic Solutions, part of Catalyst Corporate Federal Credit Union in Plano, Texas.

“Most regulatory guidelines are not obstructive and are reasonable in their intent, but there needs to be a more balanced approach in assessing risk exposure,” said Turner. “If you were to ask most credit union managers, they’d say the challenge is dealing with the unbalanced interpretation and intervention by certain field examiners.”

Despite some examiners’ concerns to the contrary, however, credit unions are in a better position than banks and other for-profit financials because the average life of their earning assets are shorter than those of the competition. Even the growth of mortgage lending hasn’t significantly lengthened asset life, which across the industry remains between two and three years, according to Turner.

“Roughly 58% of credit union assets are in cash, short-term investments and vehicle loans,” said Turner. “The shorter asset duration creates less of an impact on cash flows from changes in interest rates. Therefore, income streams are not as adversely affected in a rising-rate environment as they are in the for-profit sector.”

And how much of credit unions’ aggregate industry asset portfolio does the NCUA consider at risk? Citing the wide range of specifics involved in determining risk, Worth declined to disclose a specific number.

“When you look at a credit union, interest rate risk and asset liability management risk are determined by a lot of variables,” Worth said. “It’s done on a case-by-case basis and is not something we have in a way that works well in the public space.”

In terms of funding durations, credit unions are comparable to banks and thrifts. Yet, in a rising rate environment, credit unions historically have not had to increase their non-term shares rate parallel with the upward movement of the fed funds rate or short-term treasury rates, Turner said. In fact, non-term share rates do not change for the first 250 basis point movement in the fed funds rate.

“This suggests that as market rates increase, marginal asset yields will advance at a greater pace than funding rates,” said Turner. “This will increase net margins, specifically during the first part of the new interest rate cycle.”

Both Turner and Worth believe that credit unions won’t see a rise in rates during 2014 due to continued consumer anxiety over job security and ongoing economic uncertainty. When rates do rise, they also won’t rise at the same rate for both short-tem and long-term instruments.

“Most likely, short-term rates will see very little movement until mid-2015, but longer-term rates will remain very volatile as market forces battle against Fed monetary policy, specifically its bond purchasing program,” Turner said. “This could bring shifts between 25 to 50 basis points over the next year.”

The distinction between long-term and short-term rates is critical to understanding interest rate risk, according to Worth. In terms of safety and soundness, one size does not fit both.

“People talk about rising and falling rates, but it matters whether we’re talking about short-term or long-term rates,” Worth said.” Interest rates are not just an up-down discussion. It’s the shape of the yield curve that matters.”

When it comes to the spread between the asset yield and the cost of funds, the rate matters less than the percentage of revenue that results, Turner explains. Failure to manage that spread effectively, more so than interest rates themselves, often determine the degree of interest rate risk a credit union can face.

Greater examiner sensitivity to that spread and how well it’s being managed could go a long way in strengthening the relationship between institution and regulator, he added.

“In some cases, over the past three years in particular, examiners have given explicit directives to credit unions against real estate lending and have tried to limit investment activities all in the name of protecting the credit union against rising rates,” Turner said. “This edict comes from a fundamental theory that financial institutions should not put longer-term assets on their books when rates are about to increase.”

Read more: The credit union-examiner tug of war ...

Some credit unions find themselves in a tug of war that once again pits profitability against safety as defined by the regulator. Instead of booking, say, a seven-year asset at 4.5%, they are told it is better to book a three-year asset like a car loan at 1.9% or invest in a three-year security at 1.25%. But since consumer demand has been soft, the credit unions end up investing in securities or certificates of deposit, according to Turner.

“Assessments seem to ignore the fact that balance sheets are not static,” Turner said. “Loans put on the books over the past three months may account for 10% of a portfolio today, but as rates increase and additional loans are booked at higher rates, those 10% additions drop to 5% of the total very quickly. In the meantime, the credit union’s earning profile has been enhanced during the duration. This seems to be lost in the examination review.”

At Eagle Community, the examination process has been a struggle over the past few years, said Rains, Continued dialogue, as well as the examiner’s understanding of the credit union’s intent, its rationale and its processes can go a long way in bridging gaps that develop between the regulator and the regulated.

“With examiners, it’s all about the credit union having a plan, being able to explain that plan and then having the examiners buy into that plan,” said Rains. “I don’t think their concerns are unwarranted, but my expectation is that my examiners should work with me.”

Such was the case when Eagle Community invested in municipal securities, one of the first credit unions to do so and something the examiner at first thought too risky. Once Rains showed them the plan, the duration of the investment and the anticipated yield, the examiner saw the positive financial impact and did not downgrade the credit union for the investment.

“If the examiners see that you’re doing things right, they should trust that you know what you’re doing and cut you a little more slack,” said Rains. “For a time things were pretty touchy here, but for the past 18 months I think things have gotten better.”